Working of the International Monetary Fund

The fund initiated its system of standby arrangement in 1952.

According to this provision instead of immediately borrowing from the IMF when it needs additional reserves, a country can obtain fund’s assurances that permission to borrow will be granted in the event that this should become necessary.

The General Agreement to Borrow was established in 1962 among IMF and ten major industrial countries (U.S., Canada, U.K., France, Italy, Germany, Japan, Belgium, Netherlands and Sweden) or group of 10. This is an example of multilateral monetary cooperation.

According to the agreement if any country among these ten is in financial trouble, then they agreed to lend funds to the IMF in times of exchange crisis. Since the early 1960s, IMF assistance to developing countries has been liberalized in several important respects. In 1963, medium term loans were made available to countries experiencing temporary declines in their export earnings because of falling export prices, adverse weather conditions or other circumstance beyond their control.

These loans do not affect countries’ normal borrowing privileges under the gold tranche and credit trenches. This compensatory financing facility was amended in 1966 to increase benefit available. In December, 1975, the criteria for drawing on the compensatory financing facility were again liberalized permitting countries to draw up to 75% of their quota (though only 50% during any 12 months period).

In additional to the compensatory financing, the IMF has developed other innovative schemes to provide greater assistance to both developed and developing countries with balance of payments difficulties. A buffer stock facility was created in 1969 to help finance the accumulation and storage of selected commodities for which international agreements had been negotiated. In 1974 the IMF made arrangements to borrow SDR 6.9 billion (about $ 8 bin) from oil exporting countries and industrialized countries whose balance of payments positions were still relatively healthy after the petroleum price increases earlier that year.

The resources in this so called oil facility were lent to developed and developing countries experiencing usually serious balance of payments problems because of the higher cost of imported petroleum. Repayment periods were as long as seven years, compared with three to five years under the IMT’s normal operations.

The oil facility was terminated in May, 1976. An extended facility was established in September, 1974 to provide assistance to countries whose balance of payments difficulties were expected to last several years. Borrowing may be spread over three years, with repayments to be made four to eight years after each purchase. Countries may borrow up to 140 percent of their quota in addition to borrowings under other facilities, so long as total borrowings do not exceed 265 percent.

A subsidy account was established in 1975 to assist countries most seriously affected by the petroleum price increases. This account subsidizes interest payments on borrowings made under the oil facility. In 1976, the IMT temporarily increased the size of the credit tranches from 100 percent of quota to 145 percent. This increase was in effect until April, 1978 when higher quotas came into effect.

Also in 1976 the IMF created a special trust fund to be financed by part of the profits from its sale of gold through periodic auctions and from voluntary contributions or loans. Resources made available from the Trust fund to the low income developing countries carry an interest rate of only 0.5%. The repayment period is 10 years including a 5 year grace period.

In 1977, the IMF approved a supplementary facility under which seven oil producing nations and seven industrial countries subscribed SDR 8.7 bin (about $ 10 bin). This facility is designed to be used in conjunction with regular borrowings in the higher credit tranches or with the extended facility. Repayment may extend over seven years, including a three and one half year grace period. Although the IMQ’s innovations may appear to be impressive it should be emphasized that the grant element in its total operations is rather minor. Most of the IMF’s resources should not be regarded as aid, and they were never meant to be. Still they are valued as balance of payments assistance and newly independent nations are usually quick to seek IMF membership.

In April, 1976 after prolonged negotiations a new structure for the international monetary system was agreed to in Kingston, Jamaica. The Jamaica Agreement virtually amounts to a rebirth for the IMF. The Jamaica Agreement is the basis of the current world monetary system.

This agreement gives a completely new shape to IMF.

The main points of the Jamaica Agreement are the following:

(i) The system of managed floating (flexible) exchange rates was formally accepted. This gives recognition to each country’s right to determine its own domestic stabilization policies consistent with the interests of international stability and growth.

(ii) The official price of gold has been removed. It was agreed to sell promptly in the open market one sixth of the IMF’s holdings of gold and to return another one sixth to member nations. All IMF obligations to use gold have been put an end to. Member nations have been left free to dispose of their gold as they desire.

(iii) IMF quotas have been increased by a third with an increased share going to the developing countries so was to ease the adjustment problems of nations facing balance of payments difficulties.

(iv) It has been decided to establish SDKs as the principal reserve asset of the international monetary system, replacing both gold and dollars. This new agreement approves the system of managed floating exchanges and gives wide freedom to member countries to manage their exchange rates. It attempts to realize the advantages of floating exchange rates while at the same time preserving the need to cooperate for international stability and ensuring a rational basis for determining the total supply of international monetary reserve:

The success of the reformed international monetary system depended upon now well the following four basic problems could be solved:

1. The adjustment problem,

2. The liquidity problem,

3. The confidence, problem and

4. The problem of world inflation.

1. The adjustment problem is concerned with the most efficient way of solving a major disequilibrium in the balance of payments. It is the problem of eliminating imbalance in the international Payment. This could not be solved by exchange rate changes under the IMF scheme in the past as exchange rates remained fixed. Exchange rate changes and exchange controls were not favoured by the IMF for correcting deficits in the balance of payments. Under the old IMF system there was the absence of an adequate balance of payments mechanism to correct international imbalances.

This defect of the IMF system was overcome in the past by countries violating the rules of the fund and allowing the rates of exchange to vary more freely under the influence of the market forces. This is called the system of floating exchange rates. If all currencies floated freely, such imbalance in the international payments would be easily corrected. This realization received formal acceptance in the Jamaica Agreement. Instead of leaving the exchange rates to market forces, governments insist on some intervention for a managed float. If the “management” is limited the Smoothing short-run fluctuations managed floating rates may provide most of the advantages of completely flexibility while avoiding some of its disadvantages.

2. The term international liquidity refers to all those financial resources and facilities which are available to monetary authorities of different countries for financing the deficits in their international balance of payments. World trade has increased rapidly requiring more reserves. International lending has also increased very fast. Compared to this the world gold stock has grown only slowly and much of the new gold is not available for monetary purposes. This experience shows that we cannot depend upon gold production to provide the required amount of new international reserve each year.

In search of a solution to world liquidity problem the IMF adopted a scheme for deliberate creation of an international reserve asset in the form of Special Drawing Rights (SDRs). The introduction of the SDKs is a far-reaching reform so far made within the sphere of IMF.

These are described as a type of legal tender or paper gold in international payments. SDRs are expected to supplement the traditional reserve assets such as gold, and foreign exchange to solve the problem of international liquidity. The scheme of SDRs was approved in principle at the annual meeting of the IMF at Rio de Janeiro in September, 1967 and agreed in detail at Stockholm in 1968 but came into operation in January, 1970.

When people who hold any currency expect that its value is likely to fall in terms of other currencies they would tend to sell the currency in which they are losing confidence. This is the confidence problem, sometimes called the “hot money” problem. The problem of confidence is the problem of a fight from one reserve asset such as dollar into another reserve asset, such as gold or yen or mark. The confidence problem is still an unresolved one for the international monetary system although it is less serious now than under the old fixed rate system.

Inflation is one of the biggest economic maladies faced by most of the countries in the world. Ail countries have created new money to finance new social, military and economic programmes. This has resulted in enormous increase in expenditures. Inflation in different countries have been linked together through increasing interdependence. The huge growth in domestic money supplies and in international reserves have played a major role in aggravating the inflationary trends. Unless inflation is controlled, the balance of payments difficulties cannot be removed.

If the balance of payments difficulties continue, borrowing from the IMF would go on increasing. As a result the IMF has to find out more and more resources through increasing quotas and otherwise to help the member countries to tide over their balance of payments deficit. Therefore, if inflation continues unchecked, it may be difficult for the IMF to go on increasing liquidity indefinitely.

The oil shocks of the 1970s, which forced many oil importing countries to borrow form commercial banks, and the Interest rate increases in industrial countries trying to control inflation led to an international debt crisis in 1982. The Structural Adjustment Facility, one of the predecessors of the Poverty Reduction and Growth Facility was established in 1986, enabling the IMF to lend at below market rates to poor countries. To increase the resources available for concessional lending to developing member countries, the IMF introduced the Enhanced Structural Adjustment Facility in 1987. Throughout the 1980s, the IMF played a central role in helping resolve the crisis.

In 1992, the Russian Federation and 13 of the 14 other states of the former Soviet Union joined the IMF in 1995, an $ 18 billion loan was negotiated for Mexico to help the country recover from a capital account crisis. In 1996, the IMF and the World Bank, jointly launched the Heavily Indebted Poor Countries (HIPC) Initiative with the aim of reducing the external debt of the World’s poorest and heavily indebted countries to sustainable levels in a reasonably short period.

In 1997-98 financial crisis erupted in Thailand followed by crises in other Southeast Asian countries. The IMF provided loans totaling more than $ 36 bin to Indonesia, Korea and Thailand in support of stabilization policies and structural reforms. The crisis spilled over to countries in other areas, such as Russia, whose currency was devalued. Russia defaulted on its debt.

In 1999, the IMF replaced the Enhanced Structural Adjustment Facility with the Poverty Reduction, and Growth Facility which gave explicit attention to Poverty. Reduction and the HIPC Initiative was enhanced to provide faster, broader, and deeper debt relief. In 2000, the UN Millennium Development Goals were agreed by world leaders at the UN Millennium Summit. In 2001, Argentina suffered a financial crisis and a deep recession, defaulted on its debt, and was forced to abandon its currency board pegging the peso to the US dollar. In 2005, the G-8 launched the Multilateral Debt Relief Initiative, and the IMF agreed to forgive 100 percent of the $ 3.3 billion debt owed to it by 19 of the world’s poorest countries.